Stock Star Rating Performance Review

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1 Our top-rated stocks continue to do well, turning in very respectable performance in I m happy that our patient strategy of recommending only stocks trading at a price that includes a reasonable margin of safety is paying off nicely for consumers of our research. As we have for the past few years, we measure our performance by constructing a hypothetical portfolio that buys stocks with 5-star Morningstar Ratings for stocks, sells them if they are have 1-star ratings, and holds them otherwise. In my last performance report, I introduced some preliminary data on two additional strategies one based on selling 5-star stocks when they have 3-star ratings, and one based on selling them at our fair value estimates. The following table shows time-weighted performance data on all three strategies over a variety of trailing time periods. I ve included returns for both the cap-weighted and equal-weighted S&P 500 indexes for reference. Please note that the returns in the table above differ somewhat from the returns posted in our last performance column. There are two reasons for this. First, there was an error in the way we were calculating the time-weighted returns for the three strategies. The error mainly affected the early years of the rating, and you can learn more about it here. It s important to note that no individual star ratings were affected, since the error was related to our calculation of portfolio returns. Also, the error only affected our time-weighted returns. The second reason is that the table above uses results compiled by Abacus Analytics, a third-party performance-measurement firm, and its methodology differs slightly from what we have used previously. How the Three Strategies Have Done Returns have been quite good for all three strategies over the past four years, though some poor calls that we made during the bear market drag down the trailing five-year and since-inception periods. Our three strategies beat the S&P 500 over all time periods, but they underperform the equal-weighted S&P 500 over periods inclusive of You ll note that the Buy at 5, Sell at 3 and Buy at 5, Sell at Fair Value strategies beat the Buy at

2 5, Sell at 1 strategy over every time period, but please bear in mind that the data above are not adjusted for transactions or taxes. This is worth noting because, as I mentioned in July s performance update, the Buy at 5, Sell at 3 and Buy at 5, Sell at Fair Value strategies have materially higher turnover than Buy at 5, Sell at 1 after all, there s no such thing as a free lunch in investing. (The average holding period for a stock in the Buy at 5, Sell at 1 portfolio is about three years, which declines to one year for the Buy at 5, Sell at Fair Value strategy and six months for the Buy at 5, Sell at 3 portfolio.) Tax considerations are not relevant for those investing via an IRA or selfdirected 401(k), but short-term capital gains taxes would take a definite bite out of the higher-turnover strategies returns in a taxable account. Generally speaking, I think it s fair to say that an investor without tax considerations could likely improve upon a low-turnover Buy at 5, Sell at 1 approach by more actively recycling capital from stocks approaching our fair value estimates to stocks that are below their 5-star prices. However, less-active investors can still do quite well by following a Buy at 5, Sell at 1 approach, especially if they re using a taxable account. It s a matter of personal preference and the availability of tax-advantaged funds more than anything else. Stocks Are Cheap? Buy More! In addition to time-weighted returns, we also calculate dollar-weighted returns. Although these are not directly comparable to market benchmarks as time-weighted returns are they do take into account a very important feature of our approach. Unlike some rating systems that seek to have a relatively constant number of buys, the number of 5-star stocks tends to rise markedly as the market falls. (For example, we had well over star stocks in late July, whereas we have only about 90 right now.) We think this contrarian aspect of our rating system is valuable in encouraging investors to allocate more capital to the market when more stocks become cheap, despite the psychological difficulty in doing so.

3 As you can see, the dollar-weighted returns are uniformly higher than the timeweighted returns, showing that our aggregate view of the market as relatively expensive or cheap has been reasonably accurate over time. The lesson here is very clear: When the market gets tough, the tough go shopping for cheap stocks and reap the rewards of doing so. The Good News What individual stocks have contributed the most to our performance? I ll focus on the Buy at 5, Sell at 1 portfolio and start with the good calls. To keep things current, I ve limited both to positions that are either still open (they haven t hit 1 star yet), or stocks that hit 1 star in the second half of The first table shows our best performers ranked by annualized return, and mainly contains our best calls over the past year or so. The stocks with the highest annualized returns belong, by and large, to fairly risky or small firms these are the kinds of companies that can pop very quickly when business turns around, or which make attractive takeover targets when they get cheap. (Digitas, Redback, and Mortgage IT were all acquired last year.) Owning most of these 5-star firms was a relatively risky proposition, and investors who take on more risk should expect to get paid well for it. The three larger stocks in the first table were all unique situations. DirectTV (DTV) dipped to what we thought was an unreasonably cheap price in late 2005, and skyrocketed in 2006 as the company slowed spending on customer acquisition, which caused its cash flow to increase tremendously. Telmex (TMX) was caught in the general emerging-markets sell-off that took place in early

4 summer 2005, which was exacerbated in its case by strong polling numbers for a Mexican presidential candidate perceived as unfriendly to business. Finally, MasterCard (MA) was simply mispriced by the market when it went public. Fears over some lingering legal issues blinded the market to the firm s incredible economics, which is why we pounded the table for the shares when they went public. The table below ranks our best calls differently. Again, I only look at positions closed in 2006, but instead of using annualized returns the table shows stocks with the highest cumulative total returns. This list contains mainly stocks that have been in the Buy at 5, Sell at 1 portfolio for some time long enough to rack up very high total returns. As you can see, looking at our best picks in these two ways creates two very different lists of companies. Our second table of good calls is weighted heavily toward firms with solid competitive advantages, and you can see that despite the tremendous runs posted by these stocks, most have not yet become overvalued enough to merit a 1-star rating. Why? Because companies with economic moats tend to create value, and thus their intrinsic values often increase as time passes.

5 The Bad News Of course, we ve made our fair share of blunders as well, and our subscribers deserve a frank accounting of our calls that lost money for investors. Top of the list is Doral (DRL), which was a spectacularly bad call. The short version of what went wrong here is that our worst-case scenario came to pass and it was much, much worse than we d initially thought possible. The lesson here is that when questionable management meets a business, like mortgage banking, that requires lots of judgment calls and which depends on the confidence of the capital markets no worst-case scenario is implausible. The leverage inherent to financial-services firms makes any good outcome better, and any bad outcome much worse. Next comes Neopharm (NEOL), a tiny biotech that cratered after a key drug failed a clinical trial. Our fair value estimate assumed a better-than-even chance of approval for the drug, based on promising data from early trials, but those results didn t hold up in later tests. If there ever was a speculative investment, this was it. We account for the possibility that things go wrong with drugs in clinical trials by weighting our cash-flow forecasts by the likelihood of approval sometimes we re right, but in this case, we weren t. Radio broadcaster Westwood One (WON) and newspaper publisher Journal Register (JRC) were both caught in the general implosion of old media stocks over the past two years, which was much more severe than we had forecast. A bet on newspapers and similar firms has been one of our most contrarian calls over the past couple of years, and in this case, the consensus seems to have been right.

6 I also want to highlight Apollo (APOL), largely because I think it falls more into the much too early column, than the we totally blew it column. That s a fine line, no question, and we were certainly much too optimistic about the sustainability of the company s growth rate when it first reached a 5-star rating in mid (Back then, for example, we were forecasting a $4.5 billion top line in 2008 our current projections are for the company to reach $2.8 billion in revenue that year.) Nonetheless, the firm still has excellent economics, and its growth has recently resumed after hitting a wall in Even after a big run off of its low, the current share price still discounts improbably low growth. Conclusion Thanks for reading our latest performance update. As always, feel free to send me an with any questions, and look for our next performance update in the second quarter. Pat Dorsey, CFA, is director of stock analysis for Morningstar. Pat Dorsey, CFA has a position in the following securities mentioned above: MA EEEE This article originally appeared on Morningstar.com on March 01, 2007.